BFSI Industry Interview

Dhawal Dalal joined Merrill Lynch Investment Managers in 1996 after receiving his MBA from the University of Dallas. He worked with the Merrill Lynch Private Client Fixed Income Division for approximately a year. He later joined Money Market Desk of Merrill Lynch Investment Managers. He returned to India in 1998 to join the Fixed Income Desk of DSP BlackRock Investment Managers Pvt. Ltd. (previously called DSP Merrill Lynch Fund Managers).

With reduction in fixed deposit interest rates in the recent months many investors, especially senior citizens, who rely on FD interest for their income are worried. What is your advice for investors who rely on fixed income investment for their income?

We believe risk-averse investors, who have traditionally been investors in fixed deposits, should consider investing in short-term fund category. Short-term funds offer benefits like diversification of assets; liquidity as well as prospects of better tax-adjusted returns if investors remain invested for more than three years and are eligible for indexation benefits under long-term capital gains. Short-term funds typically invest in fixed income assets maturing between 1 & 3 years and generally have higher allocation to high quality fixed income assets.

CPI inflation in November was the highest in the past 12 months or so. Are you worried that inflation risks will prevent RBI from reducing repo rates in the near term? When do you expect RBI to reduce interest rates next? What is your expectation of the total quantum of rate reductions in the FY 2016 – 2017?

We expect CPI to average between 5.25% and 5.5% in 2016. This is based on expectations of a normal monsoon. Any shortfall in monsoons for the third consecutive year may affect food inflation, in our opinion. Food inflation has been a key concern for inflation amid falling commodity prices and higher output gaps. Based on our expectations of range-bound CPI in 2016, we expect the RBI to reduce Repo Rate by 25 basis points in H1 of 2016 if the government remains committed on the path of fiscal consolidation.

RBI has done a number of rate cuts in 2015. When do you see the RBI rate cut actually translating into higher credit off takes?

The RBI is likely to introduce a new method of base rate calculation, based on marginal cost of lending rates starting April 1, 2016. We believe that the new method may result in efficient transmission of previous rate cuts in the economy through lower base rates. We are confident that lower lending rates may help increase credit off-take from the banking system at a suitable time.

The Federal Reserve increased interest rates by 25 bps. While the very early equity market reaction seemed positive, explain for the benefit our readers the economics of the rate hike and the impact it will have (macro-economically) on global economy, especially on emerging economies like India. Also, please explain the likely impact of the rate hike on the Rupee and interest rates over the next few months?

Expectations of a lift-off by the Federal Reserve have caused outflows from the EM and risky assets since June 2015 in favour of dollar-denominated assets. As a result, the USD has strengthened against EM currencies in 2015. The rupee has also depreciated by around 4.7% against the USD in 2015. We believe that further rate hikes by the FOMC may have potential for further strengthening of the USD and consequently further weakening of the EM currencies. However, given lower commodity prices and their positive impact on the inflation, we believe that interest rates are likely to remain lower amid signs of stable to declining inflation.

The rupee has depreciated substantially this year. How much further do you expect it to depreciate? What will be impact on foreign investment flows (both FDI and FII) in India?

The rupee has depreciated by around 4.7% against the USD in 2015. At the same time, it has out-performed on relative basis against the basket of 12 currencies in the Asian currency basket. We believe that the rupee will likely maintain a depreciating bias in 2016 as well amid overall weakening bias in the EM currencies against the dollar and trajectory of the CNY going forward.

What is your outlook on bond yields over the next 12 to 24 months?

We expect the yield curve to remain steep in 2016 as well. We expect the long-end of the yield curve (20Y+) to relatively under-perform 5-10Y segment of the yield curve in 2016 amid expectations of upward revision in the fiscal deficit in FY17 and demand-supply dynamic. We are also concerned about the recent uptick in food inflation (particularly in pulses) and hope that a normal monsoon may make food inflation a transitory factor. FY2017 is likely to witness a gross supply of Rs. 10.5 trillion (Rs. 6.5 trillion of G-Sec, Rs. 3 trillion of SDL and Rs. 1 trillion of UDAY bonds) based on our internal calculations and certain assumptions. This may result in some upward pressure on the long-end of the yield curve. Having said that, we believe there is value in 5-10Y segment of the yield curve. With the Repo Rate @ 6.75% and 10Y yield closer to 7.80%, there is sufficient yield gap for investors to consider investing in 5-10Y segment of the government bond yield curve.